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By Baruch Lev New York University May 2010© Baruch Lev. All rights reserved.

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Presentation on theme: "By Baruch Lev New York University May 2010© Baruch Lev. All rights reserved."— Presentation transcript:

1 by Baruch Lev New York University May 2010© Baruch Lev. All rights reserved

2  Our question: What’s the effect of managerial quality, or talent on corporate performance?or Are managers as important as the circumstances: Economy and industry factors, firm size, intellectual property (patents, brands)?  This is similar to the historical debate: Do people or circumstances affect history? Think: Napoleon, Hitler, Stalin and Churchhill. But what about Mikhail Gorbachev? 2

3  William Shakespeare had the right answer (in Twelfth Night, spoken by Malvolio): “Some men are born great, some achieve greatness, and some have greatness thrust upon them.” both  So, like all complex questions- does heredity or the environment shape us?—the answer is both. Managers are clearly crucial for corporate success (otherwise, why pay them so much?). 3

4  Compare how Citigroup and JPMorgan Chase weathered the 2007-2008 financial crisis.  Lou Gerstner saved IBM, starting in 1993 (Share price increased during his tenure from $12 to $103)  Compare Jack Welch’s leadership of General Electric (1981-2001: Share price increased from $0.50 to $33.50) with Jeff Immelt’s ( 2001- today: share price decreased from $33.50 to $13.87)  And what about Warren Buffet at Birkshire Hathaway? (1965-2007: EPS rose from $4.00 to $4,093). 4

5  Managerial quality is a “big issue” in the business world:  Huge and controversial managerial compensation  Leadership issues in business school courses and books  Managers as celebrities  Economic and finance theories all but ignore managerial quality and impact. Emphasis on factors of production: capital, labor, etc.; industrial structure; and supply and demand conditions. 5

6  The effects of overconfident managers: They overinvest in poor projects and M&As. (Malmendier and Tate, Journal of Finance, December 2005).  CFOs style (gender, age, educational background): Older CFOs are more conservative in financial reporting; CFOs with undergraduate degrees are more aggressive (Ge et al., “Do CFOs Have Styles of Their Own?, 2008, University of Washington).  Managers’ personality and ethics predict fraud (Cohen et al., “The Role of Managers’ Behavior in Corporate Fraud,” 2008, Boston College). 6

7  Do CEOs matter? Yes. CEOs death (in Denmark at least) negatively affects future firm performance; the death of a board member has no effect on performance (Bennedsen et al., “Do CEOs Matter?” 2006, Copenhagen Business School).  Which CEOs skills matter? Execution-type skills (resolve, drive, proactive) more than interpersonal and team-related skills (a good listener). (Kaplan et al., “Which CEO Characteristics and Abilities Matter,” 2009, University of Chicago). 7 Missing: Measurement of Managerial Quality

8  Managerial quality is arguably the most important intangible asset of a company.  Managerial quality measurement is critical for a fair and effective compensation (pay) of managers. unique  Managerial quality is a major driver of corporate value and, therefore, of considerable interest to investors. Unlike other value-drivers (e.g., oil reserves, commercial property, bank branches), managerial quality is unique to the firm and therefore very hard to value. 8

9 THE MEASUREMENT OF MANAGERIAL QUALITY (An alternative calculation of managerial quality using Data Envelop Analysis (DEA), in P. Demerjian, B. Lev and Sarah McVay, “Quantifying Managerial Ability: A New Measure and Validity Tests,” 2009.) 9 Companies’ Production Function : Enterprise Performance= Physical Capital + Human Capital + R&D, Brands + Other Resources X MQ: The Enabler Stylized Example CompaniesSales GrowthPhysical Capital Growth Labor GrowthManagerial Quality A10% -- B15%10% 5%

10 LEV-RADHAKRISHNAN ESTIMATION OF MANAGERIAL QUALITY (MQ) Source: B. Lev and S. Radhakrishnan, “The Valuation of Organization Capital,” in Measuring Capital in the New Economy, National Bureau of Economic Research, 2005. 10 Revenue Growth (Cost Containment) =  1 Change Physical Capital +  2 Change No. Employees +  3 Change R&D +  4 MQ Proxied by SG&A Details: SG&A (sales, general and administrative expenses) includes most expenditures for MQ: managers’ compensation, consultants’ fees, IT expenses, advertising, etc. Estimation done yearly and within industries The form of the estimation model is multiplicative, regression run on logs of variables.


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13 Dell: Managerial Quality Leading Earnings, Sales and Stock Prices 13

14 PROOF OF CONCEPT: DOES MANAGERIAL QUALITY AFFECT SHAREHOLDER VALUE? 14 Equity Valuation Model Enterprise Value = Assets In Place + Growth Potential = Present Value Abnormal Earnings = Expected Earnings* Minus Cost of Equity + Terminal Enterprise Value Inserting our estimate of organization capital: Enterprise Value = Assets In Place + Growth Potential + Managerial Quality Finding: MQ accounts for 24% of companies’ differences in market-over-book value. *Expected corporate earnings are derived from consensus analyst forecasts.

15 MOST IMPORTANTLY: MQ PREDICT FUTURE COMPANY AND STOCK PERFORMANCE Source: B. Lev, S. Radhakrishnan and W. Zhang, “Organization Capital,” 2009, Abacus, forthcoming. 15

16 Source: B. Lev, S. Radhakrishnan and W. Zhang, “Organization Capital,” 2009, Abacus, forthcoming. 16

17  Managerial quality is crucial for company performance and shareholder value.  Managerial quality can be reliably measured, offering important applications:  Investment analysis and securities valuation.  Managerial compensation.  Corporate governance (tracking changes in MQ). 17

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